The move was the latest blow to an economy that has been
battling chronic recession, population decline and a perennial
budget shortfall that has left it with $70 billion in debt.

It also comes as the U.S. territory is preparing to return
to the bond market this month for the first time since August
with plans to raise as much as $2 billion. The downgrade is
likely to make borrowing more expensive, and it could also curb
demand.

"Now you're removing potentially a chunk of the investor
community," said James Colby, Van Eck Global chief municipal
strategist. "It does raise the bar, not to mention raise the
cost of capital."

S&P now rates the commonwealth "BB+," or one level below
investment grade, a standing that may oblige some institutional
investors to dump holdings of Puerto Rico's high-yielding debt.

Puerto Rico's bonds are popular with U.S. investors because
they are tax-free in all 50 states and offer high yields. About
70 percent of municipal-debt mutual funds own the securities,
according to Morningstar Inc.

Some Puerto Rico municipal bond yields rose above 10 percent
after the late-afternoon ratings cut. A general obligation
refunding bond maturing in 2036 hit a yield of 10.16 percent
after trading at 9.66 percent earlier in the day, though trading
volume was extremely light.

"A lot of it was priced in," said Barry HoAire, portfolio
manager at Bel Air Investments in Los Angeles. "But the big
concern is what is this going to do to Puerto Rico with respect
to margin calls and how does that strain their financial
flexibility going forward."

S&P, which had previously rated Puerto Rico "BBB-", said the
downgrade may cost the island some $940 million for penalties
and other costs tied to variable rate demand obligations and
other securities.

Analysts divided over whether or not the demotion of Puerto
Rico to junk bond territory will fan anew the fears of municipal
bond investors about other hard-pressed muni borrowers.

"People realize Puerto Rico is a one-off situation," said
Gary Pollack, head of fixed-income trading at Deutsche Bank in
New York. "While it has some problems common to other
municipalities, its stature as an island economy with a
below-average economic base and some fiscal hurdles make it
somewhat unique."

GOVERNMENT SEEKS TO REASSURE ISLANDERS

S&P Primary Credit Analyst David Hitchcock said Puerto
Rico's rating would remain in junk territory even if the island
manages to sell bonds in the weeks ahead.

If the commonwealth fails to find buyers, it would face
further downgrades by the end of the month, he said.

Puerto Rico Governor Alejandro Garcia Padilla reassured
island residents in a news conference in San Juan that the
island's government would function normally and that he would
press ahead with economic development efforts.

"My administration is not responsible for this downgrade,
but as a governor, I am responsible to lead (Puerto Rico) out of
it," Garcia Padilla said.

Puerto Rico finance officials said they were confident the
island had sufficient liquidity until June 30.

Puerto Rico's shrinking economy has for months been under
threat of a ratings downgrade by all three U.S. credit ratings
agencies. Moody's and Fitch Ratings have not announced ratings
decisions.

S&P said it worried that Puerto Rico, with 3.62 million
people, has limited ability to sell more debt and faced possible
cash shortages.

"We believe these liquidity constraints do not warrant an
investment-grade rating," S&P said in a commentary.

S&P, which also cut its rating on the island's fiscal agent,
the Government Development Bank, to BB, said that all of its
revised Puerto Rico ratings remain on negative watch.

The timing of S&P's downgrade, coming just 11 days after the
agency announced a review, was unexpected. Analysts at Moody's
have been reviewing the island's finances for a possible
downgrade since Dec. 11 and have yet to finish.

"If we have enough information to take action, we have to
release it; otherwise we're holding on to inside information,"
Hitchcock said in an interview.

"We do have confidential information on GDB cash flows and
liquidity, and, based on the information that we do have, we
feel that we had to take action."